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Too often when I ask CPAs or prospective clients if a particular company is subject to the interest limitation rules, I hear the quick answer: “No, the company is a small business and not subject.” However, the analysis is much more complex than that.
In this article I will:
a) discuss the general rules of interest limitations as laid out by Internal Revenue Code 163(j),
b) walk through the analysis that should be completed in determining if an entity is subject to the rules, and
c) review common questions and issues that I encounter as a tax practitioner that specializes in real estate taxation.
A) Overview of Internal Revenue Code (IRC) 163(j)
In 2017, The Tax Cuts and Jobs Act included a change in tax law that placed limitations on the ability to fully deduct interest for certain taxpayers after December 21, 2017. The new IRC 163(j) essentially says that a deduction for business interest shall not exceed the sum of:
The business interest income of the taxpayer,
30% of the adjusted taxable income of such taxpayer, plus
The floor plan financing interest of such taxpayer.
Adjusted taxable income (ATI) is defined as follows; taxable income of the taxpayer computed without regard to:
Income, gain, deduction, or loss that is not properly allocable to a trade or business,
Business interest or business interest income,
Net operating loss,
Deductions under IRC 199A,
For tax years beginning before January 1, 2022, any deduction allowable for depreciation, amortization, or depletion.
In most situations, for tax years starting January 1, 2022, ATI can be computed by taking the taxpayer’s taxable income and adding back business interest and expense, plus any items of income that are not allocable to the trade or business.
In simple terms, you determine your ATI, multiply it by 30%, add any business interest income, and that is the most amount of interest you can deduct.
Example of Calculating Interest Limitations
Let’s walk through a simple example.
An entity constructed a commercial building that was placed in service in 2022. The entire building is leased to a third party. Due to substantial depreciation deductions from a Cost Segregation Study they had on the property, there is an overall loss of $9,000,000. Included in the loss is depreciation deductions of $12,000,000 and interest expense of $1,000,000. The interest limitation for 2022 is calculated as follows:
Since the ATI is negative, the entire interest expense of $1,000,000 would be excess business interest and not deductible in 2022. It would carryover until a future year when there is excess taxable income allowing for the deduction.
Let’s assume that in 2023, the same entity has taxable income of $5,000,000, which includes $1,000,000 of interest expense. This would result in a full deduction of the 2023 interest expense plus excess taxable income, which could be used to deduct $800,000 of the 2022 excess interest expense.
B) Who is Subject to the Interest Expense Limitation Rules?
Not all companies are subject to the interest expense limitation rules. There is an exemption for certain “small businesses.” A small business taxpayer is a taxpayer that is not a tax shelter and meets the gross receipts test.
A tax shelter is defined as:
Any enterprise other than a C Corporation registered with a federal or state agency for offering securities for sale
Syndicate: partnership with >35% of the losses during the taxable year allocated to limited partners or limited entrepreneurs
Tax Shelter: Significant purpose of the enterprise is tax avoidance.
When I first read the new code, I thought, My clients are not tax shelters! I had the general sense that a tax shelter was an entity whose purpose was tax avoidance. However, in the real estate world, many taxpayers fall under the syndicate rules, which makes them a tax shelter for purposes of the small business taxpayer exemption.
Meeting the Gross Receipts Test
If you pass the tax shelter definition you need to see if the entity meets the gross receipts test. A taxpayer meets the gross receipts test if the taxpayer has average annual gross receipts of $27 million or less for the prior three years. However, when making this determination you must determine whether aggregation is needed under the common control rules. These rules include:
Parent Subsidiary Group Under Common Control:
Are one or more chains of the organization connected through ownership of a controlling interest (>50% profits or capital) with a common parent?
Brother-Sister Group Under Common Control:
Do the same five or fewer persons own a controlling interest (80% of profits or capital) in two of more organizations?
If your entity falls under the parent subsidiary group or brother-sister group, you must look at the entire group for purposes of determining your average annual gross receipts.
In my practice, I have found that most real estate entities fail the small business exemption. However, the rules allow for real estate entities to elect out of IRC 163(j). The election is permanent; to elect out you must use the Alternative Depreciation System, which has a slightly longer depreciable life.
Residential Real Estate:
Instead of 27.5 years for the building, you would use 30 years.
Commercial Real Estate:
Instead of 39 years for the building, you would use 40 years.
Qualified improvement property, which is normally 15 years and eligible for bonus depreciation, would be changed to a 20-year life and no longer eligible for bonus depreciation. If you often make qualified improvements that are depreciated under the bonus depreciation rules you need to evaluate the change in expected depreciation before making the permanent election.
C) Common Questions and Issues
Should I Elect Out as a Real Estate Trade or Business?
The answer to this question depends on multiple factors:
New Residential Real Estate Entity
If you have a new LLC that is placing a residential real estate building into service, the answer is generally yes: elect out as a real property trade or business. With proper tax planning you likely will have tax losses for the near term due to accelerated depreciation. Depreciating the building over 30 years rather than 27.5 will cause a small change in depreciation, much less than any interest limitation.
New Commercial Real Estate Entity
If you have a new LLC that is placing a commercial real estate building into service, this is a more complex analysis. By electing out as a real property trade or business any 15-year qualified improvement property will not be eligible for bonus depreciation. This could be a substantial change in depreciation expense.
If you have an existing entity that has been subject to interest limitations, you will want to analyze how much interest has historically been limited and what you expect in the future. It may make sense to elect out, but any past limitations are stuck until the interest is disposed.
I Should Have Been Subject to the Interest Limitations in the Past, but There Was Not a Proper Analysis. What Do I Do Now?
I see this often when I talk with new clients. In most cases, I inform the client they can amend their prior year return (or file an administrative adjustment request if not eligible to amend), but they are not required to amend. I then move forward with the current year analysis and report it properly going forward.
What if My Entity Is Subject This Year, but I Do Not Expect to Be Subject in the Future?
In some situations, it may make sense to not elect out of the interest limitation rules. Your interest will be limited in one year, but you may have excess business income in future years which will allow the past limitation to be deducted.
Overall, the key takeaway is that these new rules have added another level of complexity onto some already complex tax laws. Make sure that you are working with a CPA that specializes in real estate taxation. That way you can feel confident they are analyzing these rules and coming to you with a knowledgeable recommendation based on your specific fact patterns. If you’re looking for assistance in real estate taxation, send me an email.
This article or blog contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.